Investors seek operational excellence

The last nine months have been extremely challenging for hedge funds around the globe. Despite their relatively good performance compared to broader equity markets, investors lined up in droves to redeem capital, driving industry-wide assets down nearly 50%. A number of entities are in liquidation or restructuring, regardless of the fact that nearly a third of the overall industry was profitable in 2008. Few could have anticipated this dramatic shift early last year.

In an altered marketplace, the balance of power has shifted to investors from investment managers. Foremost, investors' calls for transparency and information have risen dramatically. Spooked by the massive Ponzi scheme orchestrated by financier and market maker Bernard L. Madoff, investors now want to know whom their money is with and what is being done to monitor potential credit risk. As a result, investors are pushing for independent custody of assets while larger investors are increasingly demanding separately managed accounts.

Furthermore, failures of storied Wall Street firms Bear Stearns and Lehman Brothers have put brokerage-related counterparty risk under the spotlight. Over the last two quarters or so, operational due diligence has become a frequently used buzzword in the marketplace. Investors are demanding greater scrutiny of assets, independent and more frequent net asset value calculations, enhanced risk management monitoring procedures and the like. Asset valuations, which as a result of market turbulence have become progressively challenging since the summer of 2007, is another key area in need of greater independence. Consequently, third-party service providers are experiencing the effect on their businesses being scrutinized thoroughly as investors increase their overall due diligence standards.

There are of course, many additional areas on which investors are now focusing. For instance, the role of the board of directors has taken centre stage, especially in the case of troubled funds. Investors increasingly want hedge fund shops to embrace good corporate governance standards by having in place a board that's objective and independent from the fund. Fees have also garnered a lot of investor attention. Largely as a result of the widespread losses recorded in 2008, investors have challenged the 2%-20% fee standard. In some cases, managers have trimmed back management fees to 1%-1.5% and are discounting future performance fees they expect to collect from continuing investors. For the first time, investors are asking hedge fund managers to consider claw-back mechanisms for performance fees, which are more commonplace in private equity funds, in order to more equitably share in both the upside and downside performance of a fund.

All told, investors are looking for both operational and performance excellence from hedge fund managers. Those funds that exhibit the ability to outperform the market in periods of uncertainty will continue to attract capital going forward. This becomes increasingly important in light of the anticipated increase in regulation, as the cost of entry for new managers will likely escalate. While startups and smaller managers may continue to attract capital from high net worth investors, they may have difficulty in lining up institutional money. One logical outcome of these investor-led changes is that large, well-established funds will become even bigger. Following this latest period of cleansing, hedge funds globally will likely emerge stronger and more nimble than ever before.